Interest on Reserves Seen as Key Fed Tool

By

Michael S. Derby

Sep 11, 2009 12:52 pm ET

Central bankers in recent speeches have flagged a new and relatively obscure tool they believe will help them control inflation when they start winding down their unprecedented provision of liquidity to banks.

The tool is the Federal Reserve‘s ability to pay interest on bank reserves held at the institution. The central bank can now compensate banks at a rate closely in line with its overnight fed funds rate target.

In theory, that makes keeping required and other reserves at the Fed an attractive option for banks. Central bankers say that power, gained last fall, allows them to get better control over the funds rate target. It also allows them to manage bank reserves more tightly, and they think it has already given them important control over prices pressures.

That’s important given the huge level of reserves banks now have after two years of extraordinary Fed liquidity provisions.

So-called excess reserves, closely watched by many inflation hawks, now stand at just under $800 billion, compared with almost negligible levels just ahead of the start of the recession. That’s in a world where the Fed’s balance sheet will likely go over $2 trillion by year end, up from around $800 billion at the start of the crisis.

If that liquidity were to flow into markets it could cause a huge inflation surge completely unwanted by policy makers. That’s why as the Fed starts to mull its eventual exit from 0% interest rates and heavy duty emergency lending, central bankers have been touting their interest paying powers as a primary tool in their bid to normalize policy.

“It’s incredibly important that they have this tool,” said Michael Feroli, an economist with J.P. Morgan Chase. It gives policy makers the breathing room to sell off their considerable store of assets at more leisurely pace, he explained.

An exit from current Fed policy lies some time away. Even so, economists believe when the Fed begins to raise rates and keeps reserves under control, it can then move more slowly to unload the considerable range of securities it has bought during the crisis. This should bring a relatively orderly unwind of all the Fed’s emergency actions.

The interest paying power is not without its uncertainties. When it was first implemented, central bankers saw optimism turn to consternation when the actual level of the funds rate remained volatile and frequently was well under what the Fed was targeting.

This consistent undershooting of the fed funds rate gave some conspiracy theorists grounds to argue the Fed was engineering a stealth interest rate easing. But they were wrong — it emerged that government-sponsored mortgage lenders Fannie Mae, Freddie Mac, and the Federal Home Loan Bank system, were in fact the primary culprits for the distortions.

Those institutions don’t get paid for their reserves, but are nevertheless big players in the short-term funding markets. Their willingness to lend out reserves at rates under the fed target distorted the market. Some believe the situation was exacerbated by last year’s horrendous market conditions, which influenced where many smaller banks were willing to park reserves.

Observers are confident these distortions will not reassert themselves in a meaningful fashion when the Fed begins raising rates and its interest rate paying powers start kicking in.

Ray Stone, of Stone & McCarthy Research Associates, said “there will be some slippage” because the agency mortgage issuers will still be there. But he expects banks to find better ways to capitalize on those distortions and smooth them out. Stone reckons the effective funds rate could end up being about 10 basis points below the target — not a big deal.